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Podcast QA2: What is Shorting and How Do People Make Money When Stocks Fall?

Podcast QA2: What is Shorting and How Do People Make Money When Stocks Fall?

Short-selling can allow somebody to make money when the price of a stock falls. I’ve been thinking for years on how to best explain this, because I myself struggled with this concept for a very, very long time. Luckily, I found a way! I share with you not only what short-selling is, but how it works, and what to be wary of. s.

With that! Here are the links. If you have iTunes please use that as it helps my rankings within the store. Don’t forget to subscribe to stay updated on future episodes!

iTunes Link

Non-Itunes (tiingo.com)

Here is the script that was used in today’s episode.

Note: I don’t follow scripts word-for-word as they can sound unnatural, but the episodes do closely follow them.

 

Hey listeners, welcome to QA.2 What is shorting?

Today we are going to discuss, what is shorting? And how can you make money when stocks go down? What are the implications of doing this with commodities or other types of financial instruments? And of course, since this is the Tiingo Investing podcast, we aren’t going to just explain what shorting is, that’s way too easy. We’re going to take shorting and then expand upon the concept to take it a few levels deeper. Everything will be easy to understand I promise.

For those of you just listening in, this is a Q&A episode. In this format we answer questions directly from our listeners.  I personally love these episodes because it means I get to interact with you all and learn what’s important to you.  Actually it’s funny, before a user asked me to explain shorting, I would spend the past couple years thinking, “if I were to teach shorting, how would I do it?” The reason I’ve been thinking about this for years is that this was a concept I struggled with for sooooo long. I mean you google it and people are like “you borrow shares and sell shares you don’t own then buy them back cheaper” And that’s the explanation. And I was still left with so many questions like “wait what? how does this all work?”

So it took me an embarrassingly long time to learn shorting and I think part of it is that sites don’t explain it well. Well I’m looking to change that in this episode and luckily I’ve been thinking about this for years. Now, I wanted to put this in the episode series, instead of Q&A, but I couldn’t figure out how. After all, the goal in these beginning episodes is investing and smart longer-term strategies. Eventually I will get into trading, but it would kinda stink to wait until episode, I don’t know, maybe 20 to learn shorting? Especially since it’s so prevalent in the media. And when a user asked, I decided, “This will be a good Q&A episode.”

Anyway, I’m going to provide a better “what is shorting” education because I can empathize with the confusion of when you google it.

Before we begin, I do want to cover a few things regarding the pace of Tiingo’s future episodes. This is going to take a couple minutes but I want to be clear why the pace of episodes is slowing down a bit. Originally, I was aiming for 1 or more episodes a week, but the truth is that the majority of my Episodes take 16-20 hours each to plan and create. Not only that, my mind is constantly thinking about how to explain things at all times.  For those of you who don’t know what Tiingo is, it’s a broader mission to make high end financial tools and education accessible to everyone.  There is a trust vacuum in finance and investing, and I want Tiingo to fill it. It’s first and foremost mission is to Actively do good. The mantra don’t be evil isn’t good enough for Finance, so Tiingo adopts “Actively be good.”  I see Tiingo as a kickstarter except better as you’re constantly building a business that provides a service to the people.  There isn’t the risk of contributing toward a product that doesn’t make its final form or really fully develop. It’s continually improving.

Anyway,  creating Tiingo allows me to develop and manage a web platform, author a podcast, interact with my users and listeners, which I love btw, and now market to get the word out. Because of all these things the past few weeks I’ve been working 8am to 2 or 3am. Actually sometimes 4 am.  I’m currently a one-man shop and thankfully many in the community are volunteering their time to help out. But in order for me to exist as a person, I have decided instead of 1 or more episodes a week, I’m going to aim for 1 or more episodes every two weeks. This is important as now we are going to get into some more complex stuff and I want to spend a lot of time making sure it’s accessible. Also this release schedule lets me sleep at a reasonable hour and have time for friend, family, and my significant other.

So I hope you can understand if the pace of episodes going forward is a bit slower. I’m still giving the same amount of time, if not more, to each epsiode and that requires a bit of a longer release schedule.

Anyway, last quick thing before we get into it – the Tiingo ecosystem, platform, and community has a “pay what you can” page. Because Tiingo costs money to run and I want to empower, I believe right now this is the best model to create a sustainable business and also empower. If you have a few minutes, I would love it if you could go to Tiingo.com/support and contribute. Even if it’s a couple dollars a month, if everybody does it, I can continue to support myself full-time. I’ve forgone over a year of income to create this project so it is helpful.  If every listener contributes $3/month or more, I can get one-step closer to making sure I can continue to do this full-time.  Think of this podcast as a constantly evolving book that interacts with us. Many of us spend $3/month on a cup of coffee, or for a book that doesn’t change throughout time. Well, why not spend another $3/month for Tiingo? Smiley face.  The link is tiingo.com/support

Anyway, that covers the pace of future episodes and a “I need to pay my bills” shpiel. Let’s move forward!

Shorting is a way somebody can make money when a stock falls. It’s a term for borrowing a shares of a stock, selling them, then rebuying the shares. You may be thinking, “uhhhh,” and that’s exactly how I felt when I heard this. So let me explain in easier terms because that explanation kinda stinks ….as usual I will explain with my favorite dessert: cookies

Let’s say your friend owns a cookie shop. You always stroll in his part of town because you buy his cookies. They aren’t any different than other cookies, and in fact your friend buys his cookies from a big company. This company sells their cookies in a ton of different stores.  Your favorite though is a bag of chocolate chip cookies, which sells for $10 a bag.

To make this scenario even more ridiculous, let’s say you’re a photographer. And you have an obsession with taking pictures of cookies. You love your friend’s chocolate chip cookies for $10/bag so much, you ask him, “hey can I borrow that bag for a hot second? I want to take a picture of it.”

Your friend thinks you’re a little creepy, but you’ve been a good customer so he says, “sure, just make sure you return the bag to me after you’re done.

You tell him that’s fine and borrow the cookies from your friend. You take some pictures of the bag, and have a friend over that night. Your friend looks at the cookies and is say, “they look so good. can I have some?” You tell him, “oh I’m just borrowing them for pictures.” Your friend who’s over looks at you funny and says, “Ok how much? I’ll buy them from you.” You realize your cookie shop friend would love it if you sold his cookies for him. So you say, “sure they’re $10.” Your friend pays you $10 and you put it on your wallet so you can give your friend the cash the next day.

The next day you walk to the cookie store to give your friend the $10 you made for him. You’re strolling along when you look to your right and see another cookie shop. You see the same cookies you just sold last night, but WAIT! you see the price….whoa.  This other cookie store is selling it for $5/bag…at your friends store they were charging  $10/bag yesterday.

You enter an existential crises of realizing you’ve been overpaying for cookies.  What is friendship? Would a friend truly make you overpay for cookies? Why would he do this to you? You’ve bought over 100 bags of cookies from him.  Why? You realize he’s not your friend and you never want to talk to him again. You say, “I don’t care about my friend, I’m going to go make a profit.”

You decide to buy the cookies for $5/bag from this other cookie shop. You go to your friends cookie shop and give him the new bag you just bought from the other store. He can’t tell the difference and thanks you. He then asks you if you want to buy cookies from him and he says the supplier dropped the cost and they are now $5 bag.

You smile because you realize he’s still your friend. You tell him no thanks and walk away.

So what just happened in this scenario? Well you borrowed the cookies from your friend, sold them that night for $10, then saw the same cookies selling for $5/bag in another store the next day. Your friend only asked you for the cookies back, but not the money. So you decided to buy a new bag at $5/bag.  You gave that bag to your cookie store friend and he couldn’t tell the difference: they were the same.

You just pocketed $5.

Once again, you borrowed a bag of cookies that normally cost $10/bag, sold them to somebody for $10 that night, and then bought that same bag of cookies for $5 the next day to give back to your friend. You sold the borrowed cookies at a higher price, then bought them back the next day at a lower price. And then you gave your friend who lent you cookies those new cookies to pay him back.

If this doesn’t make sense yet, it’s okay. Let’s continue on and talk through an example involving stocks.

Taking the perspective of stocks instead of cookies: Let’s say you see Microsoft is $40/share. You think for whatever reason the stock is going to drop. Well, you can go to your stock broker say, “hey can I borrow 10 shares real quick.” They say, “yeah sure, why not? Just give me 10 shares back at some point.”  Since pretty much all shares under the ticker MSFT, Microsoft, are the same, they don’t care if the 10 shares you give them are the ones they lent you or not. They just want 10 shares back. Remember, from episode 1,  because shares are identical, they can be traded on an exchange. 10 shares under ticker MSFT are going to have the same rights and benefits as the next 10 shares under MSFT.

So you borrow the 10 shares from your broker, and then you sell them at the market for $40/share. You collect $400 in cash for selling those 10 shares @ $40/share.

So now Microsoft drops to $35/share, and you think, “okay I’m happy here.” So you buy 10 shares @ $35/share, which costs you a total of $350. You give those 10 shares back to your broker.

Remember when you sold those borrowed shares, you made $400. Now you spent $350 to buy those shares back. Sell price minus buy price gives you profit. So you sold at $400 bought at $350. $400-$350 is a $50 profit.

OK now let’s get into some nuances.

When you ask your broker to borrow 10 shares, they actually ask a clearinghouse which has a “inventory” if you will of shares of Microsoft.  Think of them as sort of the “accountant” of your shares and everybody else’s at your brokerage. They help ensure the stock system is less risky.  Anyway, you want to borrow 10 shares and let’s say the clearinghouse has 1,000 shares of Microsoft on hand. They may say, “Ok that’s 1% of what we have that’s fine.”

But what if the clearinghouse only have 30 shares of Microsoft on hand? Well that 10 shares you want to borrow is now 30% of their inventory.

Think of this like a bank. When you go to your bank, you know the bank has enough cash to satisfy your needs if you want to take some cash out of your bank account. Well, what happens if every person who had an account at that bank asked for a cash withdrawal the same day? The bank would quickly run out of cash and not be able to service everybody. But the vast majority of the time, banks have enough cash to help people on a day-to-day basis.

The same principle holds for these clearing houses.  Their inventory of 1,000 shares of Microsoft exist, because all together, their customers have 1,000 shares. They have to make sure they have some inventory of Microsoft so if a ton of people ask to sell their shares, the clearinghouse can serve those people.

So they may feel comfortable letting you borrow 10 shares if they have 1,000 in inventory. But what if you asked for 10 shares of Microsoft when they have 30 on hand? That’s 30% of their inventory!

So to protect themselves they may say, “that’s fine, we can give 10 shares to you…but you’re going to have to pay up. You’re going to have to pay us a 50% interest rate because Microsoft right now is what we call, “hard to borrow.” You have to pay a 50% interest rate which is an annual rate. What this means, is that for every dollar you make from selling short, you have to pay 50% of it, or 50 cents each year, to the clearinghouse. So if you sold 10 shares of microsoft at $40, that’s $400. That’s $200 over the course of the year. Typically interest rates are based on 360 days to a year, so you take that $200 divide it by 360 days in a year, and that’s about $.55 a day to be short.

So if you bought back microsoft at $35/share, but it took you 100 days to do it, you would’ve paid $55 in interest to the clearinghouse.  Yet your profit was only $50. So with shorting it can not only matter if the stock drops, but also how fast it drops as you may have to pay a large interest rate, especially if it’s hard to borrow. With shorting you can very easily be in a race against time.

If you want to sell short you have to call and ask your broker what their rates are and how they handle the borrowing fee. Each broker will be different and have a different rate schedule. So before you sell short, please call them ahead. Some may charge additional fees.  This short selling interest rate process can very drastically from broker to broker. So my goal is for you to be aware that there are borrow fees and potential interest rates involved when selling short. It can get very broker specific.

The next nuance is something called margin. If you want to short, you have to open your brokerage account with margin approval. When you open up a brokerage account for the first time you can select this option .If you already have a brokerage account, you will probably have to fill out a separate form to request a margin account.

So what does margin mean? It can be confusing because it has two meanings. First, margin lets you borrow money to invest. If you have $2,000, you can apply for margin and double that. You can now trade as if you have $4,000. This is a concept called leverage. IN this case, you are levered 2 to 1. Or for every $1, you can trade $2. Remember, that your account is still only actually $2,000. If you didn’t use margin or leverage, your stocks would have to lose 100% to get wiped out and have $0 left over.

If you levered 2:1 and you traded as if you had $4,000, your account would have to lose 50% to be wiped out. So if you lost 50% of 5,000, that would result in $2,000.  So if you lost 50% when levered 2:1, you lose $21,000, which wipes you out. Using leverage can magnify losses and gains. And because of this, margin gets a second meaning. Margin is also the cushion you have. Remember the broker and clearinghouse want to protect themselves. So they may say, “okay, if you have $2,000 in your account, you can invest up to $4,000….but if your account drops below $1,500  you have to put more money in your account.” Each broker will set a different amount of what they feel comfortable with.

Because brokers and clearinghouses want to protect themselves, they will let you trade with leverage, but if you lose too much, they will ask you to transfer more money into your account. This is called a “margin call.”

But for short sellers the Federal Reserve Board requires if you short sell you have at least 150% of the value in your portfolio .For example, if you sold those 10 shares of Microsoft @40 for $400. The FRB requires you have 150% of the $400 in cash in your portfolio. That would be $600. If your account fell below that, your broker would do a margin call.

When you go to a bank for a loan, you may have cash, but it’s a liability. You owe the bank money. Treat short selling the same way. While you do get money when you sell the shares you borrowed, it’s a liability because you gotta pay your broker back. This is why you need a margin account, because you are essentially borrowing something and creating a liability.  Which gets us into the next nuance:

With short selling you can lose more money than what your account is worth. If we owned 10 shares of Facebook at $80 a share, our account would be worth $800. If Facebook went to $0, our account would be worth $0 becayse $0/share times 10 is zero. Our portfolio couldn’t be worth a negative amount, because shares can’t be worth less than $0.

But when you’re shorting, your account can go into the negatives.

Let’s say you short 100 shares of facebook at $8000. You follow the FRB requirement that you have 150% of the margin in your account. So you had $4,000 in cash, sold 100 shares of FB, and now have $12,000 of cash in your portfolio.

Let’s say markets close and FB announces amazing earnings. The stock opens the next day and starts trading immediately at $125/share. Well, if you bought those shares back right now, it would cost you $125 * 100 = $12500. Your broker would immediately do a margin call and you would be closed out immediately.

So you had $12,000 account the previous night, but you had to spend $12,500 to cover your position. You made $12k and lost $12,500k. You are $500 in the hole and owe your broker $500.

This is the thing about selling short. Stocks can go very very high, and if you’re short you’re going to lose that money. Stocks can’t go below zero, so if you buy stocks to hold long-term, you cant lose more than your account value. With shorting, you can. If the stock suddenly gaps up and catches you off guard, you can end up owing your broker money. This is not as rare s you would think so be careful.

To conclude this is shorting!  Shorting is kind of a term exclusive to stocks and ETFs, including commodity ETFs. As we will soon discuss though, when you get into commodity futures contracts – not ETFs-, you don’t really “short commodity futures.” You can sell contracts but you’re not actually borrowing the commodities. Don’t worry, we will get into these specifics in a few episodes from now. Also fun fact, if you’re a bank, you can make money from shorting stocks from the borrow. This is another topic we’ll cover in depth when we discuss what banks do in the financial sector. But just know, this is not all there is too shorting, but this episode should help you get the fundamentals down iso when you hear about it from your broker or in the news, you know what’s up.

This is such an expansive topic! So let me conclude with this: If you are a beginning investor, or even if you’re experienced, I highly highly recommend you do not short. Shorting is not investing, it’s trading ad speculating. A lot of people think trading and speculating can be fun and cool, myself included, but if you’re thinking about a long-term portfolio or retirement portfolio, it really has no place in it.

Well I hope you enjoyed this Q&A episode. If you have any questions or feedback, please shoot me an E-mail at Rishi@tiingo.com. This is a bit of a tough topic, but I’m really glad I got to answer it for you all.

 

 

 

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